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Are the stock markets a leading indicator?

Are the stock markets a leading indicator?
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First Published: Wed, May 27 2009. 09 30 AM IST

Updated: Thu, Jul 02 2009. 02 37 PM IST
Stock markets are often taken as a leading indicator of the economy. They are supposed to be forward-looking because investors are interested not so much in knowing how a company has performed in the past, but how it will perform in the present.
So, how well did the stock markets predict the turnaround after the dot-com crash? India’s bellwether equity index, the Sensex on the Bombay Stock Exchange (BSE), had reached a high of 6,150 points in February 2000, at a time when manufacturing growth, according to the Index of Industrial Production, was 8.5%. The Sensex then continued to plunge, falling to a low of 2,594 in September 2001. Manufacturing growth also declined, dipping to 3.5% in December 2000 and to a low of 1.4% in September 2001. Clearly, the crash in the stock markets preceded lower manufacturing growth. That’s easily explicable, since a market crash leads to a drying up of funding opportunities and acts as a brake to growth.
Also See Mismatch (Graphics)
But the market wasn’t such a good predictor of the upturn. Although the Sensex did turn up after September 2001, it failed to post a sustainable rally and even one-and-a-half years later at the end of April 2003, it was at 2,959. Manufacturing growth too revived after September 2001, rising over 6% by July 2002 and above 7% by September 2002. As the chart shows, the Sensex did not really predict the turn in the manufacturing index. In fact it was the other way around, with manufacturing starting to grow faster before the Sensex turned up.
But perhaps the manufacturing index is too narrow a gauge? Did the Sensex predict an upturn in gross domestic product (GDP) growth? Not really. In the third quarter of 2001-02, when the Sensex was at its lows, GDP growth was 6.8%, thanks to excellent growth in services and agriculture. During the period, GDP growth was at its lowest in the third quarter of 2002-03, when agricultural growth was a negative 12.1%. (In fact, the reason for choosing manufacturing growth rather than GDP as the indicator that should be correlated with the Sensex is because agriculture is hardly represented among the Sensex companies).
The Sensex at that time fluctuated around 3,000. And while GDP growth really accelerated in the second quarter of 2003-04, rising to 9% and to 11.3% in the third quarter, the Sensex started rallying only at the end of the second quarter of that year. Once again, it’s difficult to assign any predictive powers to the Sensex.
Perhaps the reason is because our markets are driven by foreign institutional investment flows, which is why what matters most for their performance is liquidity abroad.
Graphics by Ahmed Raza Khan / Mint
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First Published: Wed, May 27 2009. 09 30 AM IST